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CASE: Managing Offshore Investments: Whos Currency?1The Offshore Investment Fund (OIF) was incorporated in Fairfield, Connecticut, for the sole purpose of allowing U.S. shareholders to invest

CASE: Managing Offshore Investments: Whos Currency?1The Offshore Investment Fund (OIF) was incorporated in Fairfield, Connecticut, for the sole purpose of allowing U.S. shareholders to invest in Maltese securities. The Fund is listed on the New York Stock Exchange. The custodian of the Fund is the Shady Rest Bank and Trust Company of Connecticut (Shady Rest), which keeps the accounts of the Fund. The question very quickly arose as to the currency in which the books of the fund were to be kept. Shady Rest commenced writing up the books of OIF in Maltese lira, since the fund was a country fund that invested solely in listed securities on the Malta Stock Exchange. Subsequently, the Funds auditors, Big-Four, stated that, in their opinion, the functional currency should more properly by the U.S. dollar.Effects of the DecisionThe decision to adopt the U.S. dollar as the functional currency for the Fund created considerable managerial headaches. For one thing, the work of rewriting and reworking the accounting transactions was a monumental task which delayed the publication of the annual accounts. The concept of the functional currency was a foreign notion in Malta, and the effects of the functional currency choice were not clarified to the managers. Consequently, they continued to manage the Fund until late in November without an appreciation of the impact the currency choice had on the Funds results.Additional difficulties caused by the functional currency choice:a. Shady Rest, having some $300 billion in various Funds under management, still had not developed an adequate multicurrency accounting system. Whereas accounting for a security acquisition would normally be recorded in a simple bookkeeping entry, three entries were now required. In addition, payment for the purchase itself could impact the income statement in the current period.b. More serious problems related to day-to-day operations. AT the time a transaction is initiated, the Fund manager has no idea of its ultimate financial effect. AS an example, during the first year of operations, the Fund manager was certain that his portfolio sale transactions had generated a profit in excess of $1 million. When this transaction was eventually reflected in the accounts, the transaction gain was offset by currency losses totaling some $7 million!Reasons Advanced for Choosing the Dollar FunctionalBig-Four advanced the following reasons why the dollar was chosen as the Funds functional currency:Incorporation in the United StatesFunded with U.S. shareholder capital1 This case is based on an actual occurrence. The names have been changed to insure anonymity.

Dividends determined and paid in U.S. dollarsFinancial reporting under U.S. GAAP and in U.S. dollarsAdministration and advisory fees calculated on U.S. net assets and paid in U.S. dollarsMost expenses incurred and paid in U.S. dollarsAccounting records kept in U.S. dollarsSubject to U.S. tax, SEC and 1950 Exchange Act regulationsSince the Fund was set up to permit investment in Malta, it is assumed that U.S. shareholders are interested in the results of an exchange rate change on the Funds cash flows and equity; i.e., the shareholders are not only investing in Maltese securities because of attractive yields, but also gaining from a currency lay which directly affects the measurement of cash flow and equity.Managements ViewpointManagement disagreed with the auditors. Following are its rebuttal to points made by Big-Four:Incorporation n the United States with U.S. shareholders. FAS 52 clearly states that the functional currency should be determined by the primary economic environment in which that entity operates rather than by the technical detail of incorporation. Similarly, the fact that the company has U.S. shareholders and that dividends are paid in U.S. dollars are nowhere listed in FAS 52 as a consideration of relevance. In fact, the statement concerns itself throughout with the firm and its management rather than its shareholders.Financial Reporting in U.S. dollars under U.S. GAAP. The auditors fail to differentiate between reporting currency and functional currency. It is clear that the U.S. dollar should be the reporting currency but that alone does not imply that the U.S. dollar is the functional currency.Payment of certain expenses in dollars. The payment of expenses in U.S. dollars is not a reason for selecting the dollar as functional. While expenses of some $8 million for calendar 20X1 could said to have been incurred in U.S. dollars, income of over $100 million was earned in Maltese lira.U.S. tax and SEC regulations. These considerations are not relevant to the functional currency, but rather to the reporting currency.The overriding argument against the dollar as the functional currency is that such designation does not provide information that is, in the words of FAS 52, generally compatible with the expected economic effect of a rate change on an enterprises cash flow and equity. Specifically, the cash flow of the Fund from an operating point of view is entirely located in Malta, now that the initial transfer of funds raised by the issue of capital has been made. The Fund buys and sells investments in Malta, and receives all of its income from that country. If the functional currency is the Maltese lira, then realized currency fluctuations are recognized only when money is repatriated to the U.S. The

present practice of realizing an exchange profit or loss when, for example cash in Malta is exchanged or an investment purchased in Malta is both fallacious and misleading.Consider an example. Assume that the Fund deposits 1,000,000 in a Maltese bank, when the exchange rate is 1 = $3. A week later when the exchange rate is, say, 1 = $2.90, the Fund purchases and pays for an investment for 1,000,000, which it sells for cash on the same day, having decided the investment was unwise. Ignoring transaction costs, it has 1,000,000 in cash in Malta both at the beginning and at the end of the week. If the functional currency is Maltese lira, there is no realized gain or loss. However, on translation to dollars, there is an unrealized currency loss of $100,000, which would only be realized if and when the amount in question is repatriated to the United States. This conforms with common sense; it is analogous to the purchase of a stock whose price has fallen. If the U.S. dollar is the functional currency, the transaction in question would result in a realized loss on exchange of $100,000. IN terms of any common sense view of cash flow, this result is absurd; indeed, it highlights that, given the raison detre of the Fund in question, the effect on adopting the U.S. dollar as the functional currency on reporting of income is equally absurd. The net asset value of the Fund is determined each week in U.S. dollars, and reported to stockholders on that basis. This is entirely consistent with the view of the U.S. dollar as the appropriate reporting currency. Using the dollar as the functional currency implies that, on each transaction, there is a realistic and practical option of moving between the two currencies involved. This is patently incorrect; the Fund will only repatriate the base capital under two circumstances: if the Fund is liquidated or as a purely temporary expedient, if Maltese yields fall below U.S. yields. General Thrust of FAS 52The language of FAS 52 indicates that its authors did not write it with direct reference to a situation such as that of Offshore Investment Fund; i.e., a company that raises money for the single purpose of investing it in a foreign country. FAS 52 seems rather to be compiled from the viewpoint of an operating holding company owning a separate and distinct foreign operating subsidiary.FAS 52 defines the functional currency as the currency of the primary economic environment in which that entity operates. Had the Fund been incorporated in Malta and, as a separate entity, borrowed the funds from its U.S. parent, use of the local currency would have been automatic. If substance is to prevail over form, the conclusion is inescapable that the Maltese lira should still be used.Paragraph 6 of FAS 52 states, For an entity with operations that are relatively self-contained and integrated within a particular country, the functional currency generally would be the currency of that country. This reinforces the operational aspect that governs the choice of the functional currency; it is surely illogical to argue that the operations of the Fund are conducted anywhere but in Malta.

Paragraph 8 reinforces the contention that managements judgment will be required to determine the functional currency in which financial results and relationships are measured with the greatest degree of relevance and reliability.Finally, a very clear distinction is drawn in paragraphs 80 and 81, which reinforces our (managements) contention. Paragraph 80 reads, In the first class are foreign operations that are relatively self-contained and integrated within a particular country or economic environment. The day-to-day operations are not dependent upon the economic environment of the parents functional currency the foreign operation primarily generates and expends foreign currency. The foreign currency net cash flows that it generates may be reinvested and converted and distributed to the parent. For this class, the foreign currency is the functional currency.This should be contrasted with paragraph 81, which states, In the second class . . . the day-to-day operations are dependent on the economic environment of the parents currency, and the changes in the foreign entitys individual assets and liabilities impact directly on the cash flows of the parent company in the parents currency. For this class, the U.S. dollar is the functional currency.Since the entire purpose of single country funds is to create entities of the first, rather than the second class, Paragraph 80 precisely describes the operations of Overseas Investment Fund.REQUIRED:On the basis of the arguments presented, what do you feel should be the functional currency in the case?

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